Equity markets lost momentum last week, with the main indices retreating from historically high levels. Speeches by ECB President Draghi and Bank of England Governor Carney at last week’s ECB forum in Sintra, Portugal, did not leave investors indifferent. Draghi’s clarity on a potential adjustment of the ECB’s loose monetary policy was, in our view, (over)interpreted by investors as a hawkish turn, triggering a selloff in bonds and equities. Nevertheless, market volatility remains at record lows. The economic backdrop was more positive, with European core inflation picking up and the German business climate index hitting an all-time high (see charts). On the other side of the Atlantic, US first-quarter GDP was revised up slightly to 1.4%.
HAVE CENTRAL BANKS’ REACTION FUNCTIONS CHANGED?
Last week’s meeting of European central bankers in Sintra for what amounts to a European version of the annual Jackson Hole gathering organised by the US Federal Reserve discussed how to cope with steady low inflation and rising asset prices. Thus far, the main focus and the official task of the ECB has been to keep inflation at close to, but below, 2%. However, the expansive monetary policy of recent years has so far not been successful, with inflation stuck at below-target levels. What this policy has done is to send asset prices soaring to levels that are above their fair values.
Central banks may now want to stray away from their focus on inflation and implement more prudential measures to rein in asset price inflation and avoid the development of risky asset bubbles. This would mean turning more hawkish despite inflation undershooting official targets. Such a change in the policy reaction function would suggest that they would only reduce their tightening policy in the event of greater deflationary risk.
Another interpretation of such a hawkish turn is that the ECB wants to stay ahead of the curve to prevent inflation from rocketing to undesirable levels in an overheating economy. Overall, this topic suggests central banks are considering a potential change in their policy framework that could have major implications for markets.
ASSET ALLOCATION: US REAL ESTATE HAS UPSIDE
We think US equities are more overvalued than European ones. As the UK market is more correlated to US equities, we are overweight Eurozone equities versus UK equities. This also reflects the fact that our forecasts for UK equities are much lower than the consensus expectations.
The situation is different for real estate: European stocks have rallied significantly so far this year, whereas the performance of US real estate has been more muted (see chart). We are overweight US real estate to take advantage of this divergence, which we expect to revert over the coming months as US real estate benefits from growing demand and limited supply. We have neutralised the duration risk by counterbalancing this position with an underweight in US government bonds.
High-yield markets look overvalued. In particular, we think they have not adjusted enough to the recent drop in oil prices and the risk of rising default rates in the US energy sector. This segment accounts for about 30% of the high-yield markets.
In emerging markets, we believe US dollar-denominated debt is overvalued relative to local currency debt. To express this view, we are overweight local currency debt versus dollar-denominated debt. This should allow us to benefit from currency gains since several emerging market currencies should appreciate from currently low levels.
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